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A Taxing Problem in Mexico

Of all the numbers that came out of President Peña Nieto’s historic “fiscal reform” announcement this week, there’s only one that really matters: 60%.

The chart above shows how VAT (IVA) hits the different deciles of the Mexican economy. At first glance, what it shows is striking: the bottom income decile pays more of its income in VAT than any other decile. The fact that high sales taxes disproportionately affect the poor is no great surprise to most. But what is even more interesting is that, for many of these Mexicans, IVA is the only type of tax that they pay on a regular basis.

Yes, the VAT percentages may rise and the amount Mexicans can deduct from their tax bill may fall, gas subsidies may fall and capital gains taxes rise, but the real problem of Mexico’s economy is this 60%. But don’t be fooled: it’s not the nearly 70 million people that fall within this group, but rather what the size of the group says about the nature of the Mexican economy.

At the same time, the informal economy in Mexico is vibrant, creative and relatively efficient. It reflects a society of micro-entrepreneurs and artisans, city and country folk, and a broad spectrum of Mexico’s multicultural citizens. But it also operates completely off the radar of the tax authority, which means that its participants don’t contribute to the tax base as income taxpayers or collect or report VAT/sales tax. They do pay, however, on the goods and services that can’t fly under the radar, and these purchases are generally higher value, like electronics or appliances – helping contribute to the high proportional taxation.

Nonpayment of income or social security taxes has ramifications, however, and many also do not receive important services such as pensions and unemployment insurance. This makes these groups vulnerable to catastrophic events and also fails to capture small tax revenues from a very large base.

But informality goes far beyond the legislative structure of taxation and social spending. Instead, the culture of informality and of evading state control betrays an economic attitude (at all levels of society) that is adept at putting one’s own interests above those of the state. Combined with a political class which doesn’t instill much confidence in its spending habits, there is a noxious culture in Mexico of avoiding taxation.

Taking a page off of its Southern European cousins, there are a number of Mexicans who operate under the following tax mantras:

“I don’t pay taxes because I don’t trust how they are spent.” – Everyone

“Fulanito (so-and-so) told me how he avoids taxes, so I do the same” – Middle class

Taking another look at the VAT numbers and a closer look at who participates in the formal economy shows another uncomfortable truth: that the country’s small but robust middle class, concentrated in its big cities, is bearing the brunt of taxation. Despite paying a smaller proportion of its income in VAT payments, it is the group that is the most heavily affected by income taxes.

On one side, the informal economy operates under the radar of the tax authorities. On the other side, zealous private banks and diffuse capital gains oversight can hide many of the assets and earnings of the wealthiest Mexicans. For the poorest Mexicans, the only way to sell this reform is to make certain that pension and unemployment insurance reform goes through as planned. For the wealthiest, the gains are less obvious, but I’m certain they’re in the fine print somewhere. It’s the middle class that has the most to lose from this reform if it’s not executed correctly. Instead of seeing better services from their already disproportionate tax payments, they’ll likely see higher taxes to pay for substandard services for those who were never in “the system” in the first place.

I applaud President Peña Nieto for taking on one of the toughest political challenges the country faces, particularly at the same time he is looking to reduce the country’s fiscal dependence on its oil resources. But when it comes to taxation, passing laws is the easy part. Changing culture takes a lot longer. Beyond showing all Mexicans what the value of the reform is to each one of them, he is going to have to convince his countrymen a new way at looking at civic engagement and a new culture of personal responsibility around paying taxes.